chap002 AccountingMBA

Chapter 2Investing and Financing Decisions andthe Balance Sheet

ANSWERS TO QUESTIONS

1. The primary objective of financial reporting for external users is to provide useful economic information about a business to help external parties, primarily investors and creditors, make sound financial decisions. These users are expected to have a reasonable understanding of accounting concepts and procedures. Usually, they are interested in information to assist them in projecting future cash inflows and outflows of a business.

2. (a) An asset is a probable future economic benefit owned by the entity as a result of past transactions.

(b) A current asset is an asset that will be used or turned into cash within one year; inventory is always considered a current asset regardless of how long it takes to produce and sell the inventory.

(c) A liability is a probable debt or obligation of the entity as a result of a past transaction, which will be paid with assets or services.

(d) A current liability is a liability that will be paid in cash (or other current assets) or satisfied by providing service within the coming year.

(e) Contributed capital is the financing provided to the business by owners; usually owners provide cash and sometimes other assets such as equipment and buildings.

(f) Retained earnings are the cumulative earnings of a company that are not distributed to the owners and are reinvested in the business.

McGraw-Hill/ Irwin © The McGraw-Hill Companies, Inc., 2009 Financial Accounting, 6/e 2-1

3. (a) The separate-entity assumption requires that business transactions are separate from the transactions of the owners. For example, the purchase of a truck by the owner for personal use is not recorded as an asset of the business.

(b) The unit-of-measure assumption requires information to be reported in the national monetary unit. That means that each business will account for and report its financial results primarily in terms of the national monetary unit, such as Yen in Japan and Australian dollars in Australia.

(c) Under the continuity or going-concern assumption, businesses are assumed to operate into the foreseeable future. That is, they are not expected to liquidate.

(d) The historical cost principle requires assets to be recorded at the cash-equivalent cost on the date of the transaction. Cash-equivalent cost is the cash paid plus the dollar value of all noncash considerations.

4. Accounting assumptions are necessary because they reflect the scope of accounting and the expectations that set certain limits on the way accounting information is reported.

5. An account is a standardized format used by organizations to accumulate the dollar effects of transactions on each financial statement item. Accounts are necessary to keep track of all increases and decreases in the fundamental accounting model.

6. The fundamental accounting model is provided by the equation:Assets = Liabilities + Stockholders' Equity

7. A business transaction is (a) an exchange of resources (assets) and obligations (debts) between a business and one or more outside parties, and (b) certain events that directly affect the entity such as the use over time of rent that was paid prior to occupying space and the wearing out of equipment used to operate the business. An example of the first situation is (a) the sale of goods or services. An example of the second situation is (b) the use of insurance paid prior to coverage.

8. Debit is the left side of a T-account and credit is the right side of a T-account. A debit is an increase in assets and a decrease in liabilities and stockholders' equity. A credit is the opposite -- a decrease in assets and an increase in liabilities and stockholders' equity.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2009 2-2 Solutions Manual

9. Transaction analysis is the process of studying a transaction to determine its economic effect on the entity in terms of the accounting equation:

Assets = Liabilities + Stockholders' EquityThe two principles underlying the process are:

* every transaction affects at least two accounts.* the accounting equation must remain in balance after each

transaction.The two steps in transaction analysis are:

(1) identify and classify accounts and the direction and amount of the effects.

(2) determine that the accounting equation (A = L + SE) remains in balance.

10. The equalities in accounting are:(a) Assets = Liabilities + Stockholders' Equity(b) Debits = Credits

11.The journal entry is a method for expressing the effects of a transaction on accounts in a debits-equal-credits format. The title of the account(s) to be debited is (are) listed first and the title of the account(s) to be credited is (are) listed underneath the debited accounts. The debited amounts are placed in a left-hand column and the credited amounts are placed in a right-hand column.

12. The T-account is a tool for summarizing transaction effects for each account, determining balances, and drawing inferences about a company's activities. It is a simplified representation of a ledger account with a debit column on the left and a credit column on the right.

13. The financial leverage ratio is computed as average total assets divided by average stockholders’ equity (where “average” is the average of the beginning and ending balances for the year). It measures the relation between total assets and the stockholders’ capital that finances them. The higher the ratio, the more debt has been assumed by the company to finance its assets.

14. Investing activities on the statement of cash flows include the buying and selling of productive assets and investments. Financing activities include borrowing and repaying debt, issuing and repurchasing stock, and paying dividends.

MULTIPLE CHOICE

1. b 6. c2. d 7. a3. d 8. d4. a 9. b5. d 10. a


Authors' Recommended Solution Time(Time in minutes)

Mini-exercises Exercises ProblemsAlternate Problems

Cases and Projects

No. Time No. Time No. Time No. Time No. Time1 3 1 8 1 20 1 20 1 152 3 2 15 2 25 2 25 2 153 4 3 8 3 40 3 40 3 154 4 4 10 4 15 4 15 4 205 5 5 10 5 40 5 206 3 6 10 6 20 6 157 3 7 10 7 208 6 8 15 8 259 6 9 20 9 30

10 6 10 20 10 2011 4 11 15 11 *12 4 12 20

13 2014 2015 2016 1517 1018 1019 1520 10

* Due to the nature of these cases and projects, it is very difficult to estimate the amount of time students will need to complete the assignment. As with any open-ended project, it is possible for students to devote a large amount of time to these assignments. While students often benefit from the extra effort, we find that some become frustrated by the perceived difficulty of the task. You can reduce student frustration and anxiety by making your expectations clear. For example, when our goal is to sharpen research skills, we devote class time discussing research strategies. When we want the students to focus on a real accounting issue, we offer suggestions about possible companies or industries.


MINI-EXERCISES

M2–1.

C (1) Separate-entity assumption

H (2) Historical cost principle

G (3) Credits

A (4) Assets

I (5) Account

M2–2.

D (1) Journal entry

C (2) A = L + SE, and Debits = Credits

A (3) Assets = Liabilities + Stockholders’ Equity

I (4) Liabilities

B (5) Income statement, balance sheet, statement of retained earnings, and statement of cash flows

M2–3. (1) Y

(2) N

(3) Y

(4) N

(5) N

(6) Y


M2–4.

CL (1) Accounts Payable

CA (2) Accounts Receivable

NCA (3) Buildings

CA (4) Cash

SE (5) Contributed Capital

NCA (6) Land

CA (7) Merchandise Inventory

CL (8) Income Taxes Payable

NCA (9) Long-term Investments

NCL (10) Note Payable (due in three years)

CA (11) Notes Receivable (due in six months)

CA (12) Prepaid Rent

SE (13) Retained Earnings

CA (14) Supplies

CL (15) Utilities Payable

CL (16) Wages Payable

M2–5.Assets = Liabilities + Stockholders’ Equity

a. Cash +20,000 Notes payable +20,000

b. Cash –7,000Notes

receivable+7,000

c. Cash +1,000 Contributed capital

+1,000

d. CashEquipment

–6,000+15,000

Notes payable +9,000

e. Cash –2,000 Retained earnings

–2,000


M2–6.Debit Credit

Assets Increases DecreasesLiabilities Decreases IncreasesStockholders’ equity Decreases Increases

M2–7.Increase Decrease

Assets Debit Credit

Liabilities Credit Debit

Stockholders’ equity Credit Debit

M2–8.

a. Cash (+A)............................................................................ 20,000Notes Payable (+L)........................................................ 20,000

b. Notes Receivable (+A)......................................................... 7,000Cash (A)........................................................................ 7,000

c. Cash (+A)............................................................................ 1,000Contributed Capital (+SE).............................................. 1,000

d. Equipment (+A).................................................................... 15,000Cash (A)........................................................................ 6,000Notes Payable (+L)........................................................ 9,000

e. Retained Earnings (SE)...................................................... 2,000Cash (A)........................................................................ 2,000

M2–9.Cash Notes Receivable Equipment

Beg. 800 Beg. 900 Beg. 15,000(a) 20,000 7,000 (b) (b) 7,000 (d) 15,000(c) 1,000 6,000 (d)

2,000 (e)6,800 7,900 30,000

Notes Payable Contributed Capital Retained Earnings2,700 Beg. 5,000 Beg. 9,000 Beg.

20,000 (a) 1,000 (c) (e) 2,0009,000 (d)

31,700 6,000 7,000


M2–10.Bandera Inc.

Balance SheetAt January 31, 2011

Assets LiabilitiesCurrent assets: Current liabilities:

Cash $ 6,800 Notes payable $ 31,700Notes receivable 7,900 Total current liabilities 31,700 Total current assets 14,700 Stockholders’ Equity

Contributed capital 6,000Equipment 30,000 Retained earnings 7,000

Total stockholders’ equity 13,000

Total Assets $44,700Total Liabilities & Stockholders’ Equity $44,700

M2–11.

Financial = Average Total Assets = ($240,000+$280,000) / 2 = $260,000 = 1.73Leverage Average Stockholders’

Equity($140,000+$160,000) / 2 $150,000

This ratio indicates that, for every $1 of equity investment, Sal’s Pizza maintains $1.73 of assets. Sal’s Pizza’s ratio is lower than Papa John’s 2006 ratio (of 2.37), indicating that Sal’s Pizza maintains a lower debt level and follows a less risky financing strategy than does Papa John’s.

M2–12. (a) F

(b) I

(c) F

(d) I

(e) F


EXERCISES

E2–1.

E (1) Transaction

F (2) Continuity assumption

B (3) Balance sheet

P (4) Liabilities

K (5) Assets = Liabilities + Stockholders’ Equity

H (6) Historical cost principle

M (7) Note payable

O (8) Dual effects

N (9) Retained earnings

D (10) Debits

C (11) Separate-entity assumption

A (12) Current assets

J (13) Accounts receivable

Q (14) Unit-of-measure assumption

I (15) Account


E2–2.

Req. 1

Received Given

(a) Equipment (A) [or Computer equipment] Note payable (L)

(b) Equipment (A) [or Delivery truck] Cash (A)

(c) No exchange transaction —

(d) Cash (A) Contributed capital (SE)

(e) Building (A) [or Construction in progress] Cash (A)

(f) Intangibles (A) [or Copyright] Cash (A)

(g) Retained earnings (SE) [Received a reduction in the amount available for payment to stockholders]

Cash (A)

(h) Investments (A) Cash (A)

(i) Land (A) Cash (A)

(j) Intangibles (A) [or Patents] Cash (A) and Note payable (L)

(k) No exchange transaction —

(l) Cash (A) Short-term note payable (L)

(m) Note payable (L) [Received a reduction in its promise to pay]

Cash (A)

Req. 2The truck in (b) would be recorded as an asset of $21,000. The land in (i) would be recorded as an asset of $50,000. These are applications of the cost principle.

Req. 3The agreement in (c) involves no exchange or receipt of cash, goods, or services and thus is not a transaction. Since transaction (k) occurs between the owner and others, there is no effect on the business because of the separate-entity assumption.


E2–3.

AccountBalance Sheet Categorization

Debit or CreditBalance

(1) Land NCA Debit

(2) Retained Earnings SE Credit

(3) Taxes Payable CL Credit

(4) Prepaid Expenses CA Debit

(5) Contributed Capital SE Credit

(6) Long-term Investments NCA Debit

(7) Machinery and Equipment NCA Debit

(8) Accounts Payable CL Credit

(9) Short-term Investments CA Debit

(10) Notes Payable (due in 3 yrs) NCL Credit

E2–4.

Event Assets = Liabilities + Stockholders’ Equity

a. Cash +24,000 Contributed capital +24,000

b. Equipment

Cash

+8,000

–1,000

Notes payable +7,000

c. Note receivable

Cash

+500

–500

d. Cash +7,000 Notes payable +7,000

e. Land

Cash

+15,000

–4,000

Mortgage note payable +11,000


E2–5.

Req. 1Event Assets = Liabilities + Stockholders’ Equity

a. Buildings

Equipment

Cash

+182.0

+21.9

– 48.1

Notes payable (long-term)

+155.8

b. Cash +253.6 Contributed capital

+253.6

c. Dividends payable

+179.2 Retained earnings

–179.2

d. Investments (short-term)

Cash

+400.8

– 400.8

e. No effects

f. Cash

Short-term Investments

+1.4

–1.4

Req. 2The separate-entity assumption states that transactions of the business are separate from transactions of the owners. Since transaction (e) occurs between the owners and others in the stock market, there is no effect on the business.

E2–6.

a. Cash (+A)............................................................................ 24,000Contributed capital (+SE)............................................... 24,000

b. Equipment (+A).................................................................... 8,000Cash (A)........................................................................ 1,000Notes payable (+L) ........................................................ 7,000

c. Notes receivable (+A).......................................................... 500Cash (A)........................................................................ 500

d. Cash (+A)............................................................................ 7,000Notes payable (+L)......................................................... 7,000

e. Land (+A)............................................................................. 15,000Cash (A)........................................................................ 4,000Mortgage notes payable (+L) ........................................ 11,000


E2–7.

Req. 1

a. Buildings (+A)...................................................................... 182.0Equipment (+A) ................................................................... 21.9

Cash (A)........................................................................ 48.1Note payable (+L) .......................................................... 155.8

b. Cash (+A)............................................................................ 253.6Contributed capital (+SE)............................................... 253.6

c. Retained earnings (SE)...................................................... 179.2Dividends payable (+L).................................................. 179.2

d. Investments (+A)................................................................. 400.8Cash (A)........................................................................ 400.8

e. No journal entry required.

f. Cash (+A)............................................................................ 1.4Investments (A)............................................................. 1.4

Req. 2

The separate-entity assumption states that transactions of the business are separate from transactions of the owners. Since transaction (e) occurs between the owners and others in the stock market, there is no effect on the business.


E2–8.

Req. 1

Cash Note Receivable EquipmentBeg. 0 Beg. 0 Beg. 0(a) 63,000 4,000 (d) (e) 2,200 (d) 16,000(c) 4,000 2,200 (e)

60,800 2,200 16,000

Land Note Payable Contributed CapitalBeg. 0 0 Beg. 0 Beg.(c) 13,000 12,000 (d) 63,000 (a)

17,000 (c)

13,000 12,000 80,000

Req. 2

Assets $ 92,000 = Liabilities $ 12,000 + Stockholders’ Equity $ 80,000

Req. 3

The agreement in (b) involves no exchange or receipt of cash, goods, or services and thus is not a transaction. Since transaction (f) occurs between the owner and others, there is no effect on the business due to the separate-entity assumption.


E2–9.

Req. 1

Transaction Brief Explanation1 Issued capital stock to shareholders for $16,000 cash. (Cirba Sports

Inc. is a corporation.)

2 Borrowed $70,000 cash and signed a short-term note for this amount.

3 Purchased land for $16,000; paid $5,000 cash and gave an $11,000 short-term note payable for the balance.

4 Loaned $4,000 cash; borrower signed a short-term note for this amount (Note Receivable).

5 Purchased store fixtures for $9,000 cash.

6 Purchased land for $4,000, paid for by signing a short-term note.

Req. 2Cirba Sports Inc.

Balance SheetAt January 7, 2011

Assets LiabilitiesCurrent Assets Current Liabilities

Cash $68,000 Note payable $85,000Note receivable 4,000 Total Current Liabilities 85,000Total Current Assets 72,000

Store fixtures 9,000 Stockholders’ EquityLand 20,000 Contributed capital 16,000

Total Stockholders’ Equity 16,000



E2–10.

Req. 1

Transaction Brief Explanation1 Issued capital stock to shareholders for $60,000 cash.

2 Purchased a delivery truck for $30,000; paid $4,000 cash and gave a $26,000 long-term note payable for the balance.

3 Loaned $4,000 cash; borrower signed a short-term note for this amount.

4 Purchased short-term investments for $7,000 cash.

5 Sold short-term investments at cost for $2,000 cash.

6 Issued capital stock to shareholders for $4,000 of computer equipment.

Req. 2Clifford’s Cleaning, Inc.

Balance SheetAt March 31, 2010

Assets LiabilitiesCurrent Assets Notes payable $26,000

Cash $47,000 Total Liabilities 26,000Investments 5,000Notes receivable 4,000Total Current Assets 56,000

Stockholders’ EquityComputer equipment 4,000 Contributed capital 64,000Delivery truck 30,000 Total Stockholders’ Equity 64,000



E2–11.

a. Cash (+A)............................................................................ 60,000Contributed capital (+SE)............................................... 60,000

b. Cash (+A)............................................................................ 10,000Notes payable (long-term) (+L)...................................... 10,000

c. No transaction has occurred because there has been no exchange or receipt of cash, goods, or services.

d. Equipment (+A).................................................................... 12,000Cash (A)........................................................................ 1,500Notes payable (short-term) (+L)..................................... 10,500

e. Store fixtures (+A)................................................................ 20,000Cash (A)........................................................................ 20,000

f. Notes receivable (short-term) (+A)...................................... 1,000Cash (A)........................................................................ 1,000


E2–12.

a. Retained earnings (SE)...................................................... 532Dividends payable (+L).................................................. 532

b. No transaction has occurred because there has been no exchange or receipt of cash, goods, or services.

c. Dividends payable (L)......................................................... 419Cash (A)........................................................................ 419

d. Cash (+A)............................................................................ 3,956Notes payable (+L)......................................................... 3,956

e. Cash (+A)............................................................................ 2,677Equipment (A)............................................................... 2,677

f. Equipment (+A).................................................................... 12,890Cash (A)........................................................................ 9,870Notes payable (+L) ........................................................ 3,020

g. Investments (+A)................................................................. 2,654Cash (A)........................................................................ 2,654


E2–13.

Req. 1Assets $ 7,500 = Liabilities $ 500 + Stockholders’ Equity $ 7,000

Req. 2

Cash Short-Term Investments Property & EquipmentBeg. 3,000 Beg. 2,000 Beg. 2,500(a) 2,000 1,000 (b) 1,250 (c)(b) 1,000(c) 1,250 300 (d)End. 6,950 End. 1,000 End. 1,250

Short-TermNotes Payable

Long-TermNotes Payable

200 Beg. 300 Beg.2,000 (a)

200 End. 2,300 End.

Contributed Capital Retained Earnings5,000 Beg. 2,000 Beg.

(d) 300

5,000 End. 1,700 End.

Req. 3Assets $ 9,200 = Liabilities $ 2,500 + Stockholders’ Equity $ 6,700

Req. 4


Equity($7,000+$6,700) / 2 $6,850

This ratio indicates that, for every $1 of equity investment, Massimo maintains $1.22 of assets. Massimo’s ratio is lower than the industry average of 2.00, indicating that Massimo maintains a lower debt level and follows a less risky financing strategy than does the average firm in the industry. As such, Massimo can finance expansion by borrowing without taking on excessive debt compared to the industry average.


E2–14.Massimo Company

Balance SheetAt December 31, 2011


Cash $ 6,950 Short-term notes payable $ 200Short-term investments 1,000 Total Current Liabilities 200Total Current Assets 7,950 Long-term notes payable 2,300

Total Liabilities 2,500Stockholders’ Equity

Contributed capital 5,000Property and equipment 1,250 Retained earnings 1,700



E2–15.

Req. 1

CashShort-Term

Note Receivable LandBeg. 0 Beg. 0 Beg. 0(a) 40,000 4,000 (c) (d) 3,000 (b) 12,000 3,000 (d)

1,000 (e)35,000 3,000 9,000

EquipmentShort-Term

Notes PayableLong-Term

Notes PayableBeg. 0 0 Beg. 0 Beg.(c) 20,000 12,000 (b) 16,000 (c)(e) 1,000

21,000 12,000 16,000

Contributed Capital0 Beg.

40,000 (a)

40,000


E2–15. (continued)

Req. 2Chu Delivery Company, Inc.



Cash $35,000 Short-term notes payable $12,000Short-term note receivable 3,000 Total Current Liabilities 12,000Total Current Assets 38,000 Long-term notes payable 16,000

Total Liabilities 28,000Land 9,000Equipment 21,000 Stockholders’ Equity

Contributed capital 40,000Total Stockholders’ Equity 40,000


Req. 3

2011:


Equity($40,000+$50,000) / 2 $45,000

2012:


Equity($50,000+$60,000) / 2 $55,000

The financial leverage ratio has increased over the years. This suggests that the company has been taking on additional risk through debt financing.

Req. 4

The management of Chu Delivery Services has already been financing the company’s development through debt (as evidenced by the increasing leverage ratio). This suggests the company is taking on increasing risk. Based solely on the financial leverage ratio, the bank’s vice president should consider not providing the loan to the company as it currently stands. Of course, additional analysis would provide better information for making a sound decision.


E2–16.

Transaction Brief Explanation

(a) Issued capital stock to shareholders for $17,000 cash and $3,000 tools and equipment.

(b) Purchased a building for $50,000; paid $10,000 cash and gave a $40,000 note payable for the balance.

(c) Loaned $1,500 cash; borrower signed a note receivable for this amount.

(d) Sold $800 of tools and equipment for their original cost.

E2–17.

Req. 1Increases with… Decreases with…

Equipment Purchases of equipment Sales of equipment

Notes receivable Additional loans to others Collection of loans

Notes payable Additional borrowings Payments of debt

Req. 2

Equipment Notes Receivable Notes Payable

1/1 500 1/1 150 100 1/1

250 700 225 225 110 170

12/31 50 12/31 150 160 12/31

Beginning balance

+ “+” “” = Ending balance

Equipment $500 + 250 ? = $50? = 700

Notes receivable 150 + ? 225 = 150? = 225

Notes payable 100 + 170 ? = 160? = 110


E2–18.

Activity Type of Activity Effect on Cash

(a) Reduction of long-term debt F (b) Sale of land I +

(c) Issuance of common stock F +

(d) Capital expenditures I (e) Issuance of short-term debt F +

E2–19.Hilton Hotels Corporation

Partial Statement of Cash FlowsFor the year ended December 31, 2011

Investing ActivitiesPurchase of investments $(139)Purchase and renovation of properties (370)Sale of property 230Receipt of payment from note receivable 125Cash flow from investing activities (154)

Financing ActivitiesAdditional borrowing from banks 992Payment of debt (24)Issuance of stock 6Cash flow from financing activities 974

E2–20.1. Current assets In the asset section of a classified balance sheet.

2. Debt principal repaid In the financing activities section of the statement of cash flows.

3. Significant accounting policies Usually the first note after the financial statements.

4. Cash received on sale of noncurrent assets

In the investing activities section of the statement of cash flows.

5. Dividends paid In the financing activities section of the statement of cash flows.

6. Short-term obligations In the current liabilities section of a classified balance sheet.

7. Date of the statement of financial position.

In the heading of the balance sheet.


PROBLEMS

P2–1. Balance

Sheet Classification

Debit or Credit

Balance


(2) Note and Loans Payable (short-term) CL Credit

(3) Materials and Supplies CA Debit

(4) Long-term Debt NCL Credit

(5) Prepaid Taxes and Expenses CA Debit

(6) Patents (an intangible asset) NCA Debit

(7) Income Taxes Payable CL Credit


(9) Property, Plant, and Equipment NCA Debit

(10) Notes and Accounts Receivable (short-term) CA Debit

(11) Cash and Cash Equivalents CA Debit


(13) Investments (long-term) NCA Debit

(14) Crude Oil Products, and Merchandise CA Debit


P2–2.

Req. 1

Cornell Home Healthcare Services was organized as a corporation. Only a corporation issues shares of capital stock to its owners in exchange for their investment, as Cornell did in transaction (a).

Req. 2 (On next page)

Req. 3

The transaction between the two stockholders (Event d) was not included in the tabulation. Since the transaction in (d) occurs between the owners, there is no effect on the business due to the separate-entity assumption.

Req. 4

(a) Total assets = $111,500 + $18,000 + $5,000 + $510,500 + $160,000 + $65,000 = $870,000

(b) Total liabilities = $280,000

(c) Total stockholders’ equity = Total assets – Total liabilities = $870,000 – $280,000 = $590,000

(d) Cash balance = $50,000 + $90,000 – $9,000 – $18,000 – $5,000 + $3,500 = $111,500

(e) Total current assets = $111,500 + $18,000 + $5,000 = $134,500

Req. 5


Equity($500,000+$590,000) / 2 $545,000

This suggests that Cornell uses significantly more equity than debt to finance the company’s assets.


P2–2. (continued)

Req. 2

Assets = Liabilities + Stockholders' Equity

CashShort-term

InvestmentsNotes

Receivable Land Building EquipmentNotes

PayableContributed Capital

Retained Earnings

Beg. 50,000 500,000 100,000 50,000 = 200,000 100,000 400,000

(a) +90,000 = +90,000

(b) –9,000 +14,000 +60,000 +15,000 = +80,000

(c) –18,000 +18,000 =

(d) No effect

(e) –5,000 +5,000 =

(f) +3,500 –3,500 =

+111,500 +18,000 +5,000 +510,500 +160,000 +65,000 = +280,000 +190,000 +400,000

$870,000 $280,000 $590,000


P2–3.

Req. 1 and 2

Cash Investments (short-term) Accounts ReceivableBeg. 21,000 Beg. 2,000 Beg. 3,000(c) 12,000 7,000 (a) (e) 9,000(d) 12,000 6,000 (b)(h) 1,000 9,000 (e) End. 11,000 End. 3,000

3,000 (g)9,000 (i) Inventory Notes Receivable (long-term)

Beg. 24,000 Beg. 1,000(a) 7,000

End. 12,000 End. 24,000 End. 8,000

Equipment Factory Building IntangiblesBeg. 48,000 Beg. 90,000 Beg. 3,000(b) 18,000 1,000 (h) (i) 25,000 (g) 3,000

End. 65,000 End. 115,000 End. 6,000

Accounts Payable Accrued Liabilities Payable Notes Payable (short-term)15,000 Beg. 2,000 Beg. 7,000 Beg.

12,000 (b)12,000 (d)

15,000 End. 2,000 End. 31,000 End.

Long-Term Notes Payable Contributed Capital Retained Earnings48,000 Beg. 90,000 Beg. 30,000 Beg.16,000 (i) 12,000 (c)

64,000 End. 102,000 End. 30,000 End.


P2–3. (continued)

Req. 3

No effect was recorded for (f). The agreement in (f) involves no exchange or receipt of cash, goods, or services and thus is not a transaction.

Req. 4 Injection Plastics Company



Cash $ 12,000 Accounts payable $ 15,000Investments 11,000 Accrued liabilities payable 2,000Accounts receivable 3,000 Notes payable 31,000Inventory 24,000 Total Current Liabilities 48,000Total Current Assets 50,000 Long-term notes payable 64,000

Total Liabilities 112,000Notes receivable 8,000Equipment 65,000 Stockholders’ EquityFactory building 115,000 Contributed capital 102,000Intangibles 6,000 Retained earnings 30,000



Req. 5


Equity($120,000+$132,000) / 2 $126,000

This ratio indicates that, for every $1 of equity investment, Injection Plastics maintains $1.73 of assets, with the additional $0.73 of assets financed by debt. The company utilizes more equity than debt to finance assets.


P2–4.

Transaction

Type of Activity Effect on Cash

(a) I –

(b) I –

(c) F +

(d) F +

(e) I –

(f) NE NE

(g) I –

(h) I +

(i) I –

P2–5.

Req. 1

a. Cash (+A)............................................................................ 200Contributed capital (+SE)............................................... 200

b. Cash (+A)............................................................................ 30Long-term liabilities (+L)................................................. 30

c. Long-term investments (+A)................................................ 2,600Short-term investments (+A) ............................................... 10,400

Cash (A)........................................................................ 13,000

d. Property , plant, and equipment (+A).................................. 2,285Cash (A)........................................................................ 875Long-term liabilities (+L)................................................. 1,410

e. Receivables and other assets (+A)...................................... 250Cash (A)........................................................................ 250

f. Cash (+A)............................................................................ 10,000Short-term investments (A)........................................... 10,000

g. Retained earnings (SE)...................................................... 52Cash (A)........................................................................ 52


P2–5. (continued)

Req. 2

Cash Short-term

InvestmentsReceivables and

Other AssetsBeg. 7,042 Beg. 2,016 Beg. 5,452(a) 200 (c) 10,400 10,000 (f) (e) 250(b) 30 13,000 (c) 2,416 5,702(f) 10,000 875 (d)

250 (e)52 (g) Inventories Other Current Assets

Beg. 576 Beg. 2,620

3,095 576 2,620

Property, Plant and Equipment

Long-term Investments

Other Noncurrent Assets

Beg. 2,005 Beg. 2,691 Beg. 707(d) 2,285 (c) 2,600

4,290 5,291 707

Accounts Payable

Other Short-termObligations

9,840 Beg. 6,087 Beg.

9,840 6,087

Long-term Liabilities Contributed Capital Retained Earnings3,053 Beg. 284 Beg. 3,845 Beg.

30 (b) 200 (a) (g) 521,410 (d)4,493 484 3,793


P2–5. (continued)

Req. 3

Dell, Inc.Balance Sheet

At January 28, 2007(in millions)

ASSETS

Current AssetsCash $ 3,095Short-term investments 2,416Receivables and other assets 5,702Inventories 576Other current assets 2,620

14,409Noncurrent AssetsProperty, plant and equipment 4,290Long-term investments 5,291Other noncurrent assets 707

Total assets $24,697

LIABILITIES AND STOCKHOLDERS’ EQUITY

Current LiabilitiesAccounts payable $ 9,840Other short-term obligations 6,087

15,927Long-term Liabilities 4,493Stockholders’ EquityContributed capital 484Retained earnings 3,793

Total liabilities and stockholders’ equity $24,697

Req. 4 Financial = Average Total Assets = ($23,109+$24,697) / 2 = $23,903 = 5.69Leverage Average Stockholders’

Equity($4,129+$4,277) / 2 $4,203

For every $1 of equity investment, Dell utilizes $4.69 of debt to finance its assets. Dell uses more than four times as much debt as equity financing.


P2–6.Dell, Inc.

Partial Statement of Cash FlowsFor the year ended January 28, 2007

(in millions of dollars)

INVESTING ACTIVITIES

Purchase of property, plant, and equipment $ (875)Purchase of investments (13,000)Loan of funds to affiliates (250)Sale of investments 10,000

Cash flow used in investing activities (4,125)

FINANCING ACTIVITIES

Borrowings 30 Issuance of stock 200Payment of dividends (52)

Cash flow provided by financing activities 178

Net change in cash (3,947)Beginning balance of cash 7,042

Cash balance on January 28, 2007 $ 3,095


ALTERNATE PROBLEMS

AP2–1.Balance

Sheet Classification

Debit or Credit

Balance

(1) Accounts Receivable CA Debit

(2) Prepaid Expenses CA Debit

(3) Inventories CA Debit

(4) Long-term Debt NCL Credit

(5) Cash and Cash Equivalents CA Debit


(7) Income Taxes Payable CL Credit


(9) Property, Plant, and Equipment NCA Debit


(11) Short-term Borrowings CL Credit

(12) Accrued Liabilities CL Credit

(13) Goodwill (an intangible asset) NCA Debit


AP2–2.

Req. 1

Kalman Incorporated was organized as a corporation. Only a corporation issues shares of capital stock to its owners in exchange for their investment, as Kalman did in transaction (b).

Req. 2 (On next page)

Req. 3

Since the transaction in (i) occurs between the owners and others outside the company, there is no effect on the business due to the separate-entity assumption.

Req. 4

(a) Total assets = $45,000 + $2,000 + $85,000 + $107,000 + $510,000 = $749,000

(b) Total liabilities = $169,000 + $180,000 = $349,000

(c) Total stockholders’ equity = Total assets – Total liabilities = $749,000 – $349,000 = $400,000

(d) Cash balance = $120,000 – $3,000 + $100,000 + $120,000 – $5,000 – $200,000 – $85,000– $2,000 = $45,000

(e) Total current assets = $45,000 + $2,000 = $47,000

Req. 5


Equity($300,000+$400,000) / 2 $350,000

This suggests that Kalman uses slightly less debt than equity to finance the company’s assets. For every $1 of equity, there is $.78 of debt utilized in financing.


AP2–2. (continued) Req. 2

Assets = Liabilities + Stockholders' Equity

CashNotes

ReceivableLong-Term

Investments Equipment Building

Short-Term Notes

Payable

Long-Term Notes

PayableContributed Capital

Retained Earnings

Beg. 120,000 70,000 310,000 = 140,000 60,000 220,000 80,000

(a) –3,000 +30,000 = +27,000

(b) +100,000 = +100,000

(c) +120,000 = +120,000

(d) –5,000 +10,000 = +5,000

(e) –200,000 +200,000 =

(f) –85,000 +85,000 =

(g) –3,000 = –3,000

(h) –2,000 +2,000 =

(i) No effect =

+45,000 +2,000 +85,000 +107,000 +510,000 = +169,000 +180,000 +320,000 +80,000

$749,000 $349,000 $400,000


AP2–3.

Req. 1 and 2

Cash and Cash Equivalents

Short-Term Investments

Accounts Receivable

Beg. 147,879 Beg. 0 Beg. 14,602(a) 1,020 3,400 (b) (g) 2,980(c) 4,020 1,830 (e) 2,980 14,602(f) 310 2,980 (g)

300 (h) InventoriesBeg. 181,884

144,719 181,884

Prepaid Expenses and Other Current Assets

Property, Plant and Equipment

Intangibles

Beg. 38,064 Beg. 322,185 Beg. 92,500(e) 11,230 4,020 (c) (b) 3,400

38,064 329,395 95,900

Other Assets

Accounts Payable

Accrued Expenses Payable

Beg. 5,484 78,722 Beg. 68,677 Beg.310 (f)

5,174 78,722 68,677

Long-Term Debt*

Other Long-Term Liabilities

Contributed Capital

202,908 Beg. 42,649 Beg. 79,374 Beg.9,400 (e) 1,020 (a)

212,308 42,649 80,394

* Current portion is $40. Retained Earnings330,268 Beg.

(h) 300329,968

Req. 3

No effect was recorded for (d). Ordering goods involves no exchange or receipt of cash, goods, or services and thus is not a transaction.


AP2–3. (continued)

Req. 4Ethan Allen Interiors, Inc.

Balance Sheet At September 30, 2007

(in thousands of dollars)AssetsCurrent assets

Cash and cash equivalents $ 144,719Short-term investments 2,980Accounts receivable 14,602Inventories 181,884Prepaid expenses and other current assets 38,064 Total current assets 382,249

Property, plant and equipment 329,395Intangibles 95,900Other assets 5,174

Total Assets $812,718

LiabilitiesCurrent liabilities

Accounts payable $ 78,722Accrued expenses payable 68,677Current portion of long-term debt 40 Total current liabilities 147,439

Long-term debt 212,268Other long-term liabilities 42,649 Total Liabilities 402,356Stockholders’ Equity

Contributed capital 80,394Retained earnings 329,968

Total Stockholders’ Equity 410,362Total Liabilities and Stockholders’ Equity $812,718

Req. 5


Equity($409,642+$410,362) / 2 $410,002

This ratio indicates that, for every $1 of equity investment, Ethan Allen maintains $1.97 of assets, with the additional $0.97 of assets financed by debt. This suggests that Ethan Allen relies fairly equally on debt and equity financing.


AP2–4.

Transaction

Type of Activity Effect on Cash

(a) F +

(b) I

(c) I +

(d) NE NE

(e) I

(f) I +

(g) I

(h) F


CASES AND PROJECTS

ANNUAL REPORT CASES

CP2–1.

1. The company is a corporation since it maintains share capital and its owners are referred to as “shareholders.” (Refer to the stockholders’ equity section of the balance sheet).

2. The amount listed on the balance sheet for inventories does not represent the expected selling price. It represents the historical cost of acquiring the inventory, as required by the cost principle.

3. The company’s current obligations include: accounts payable, accrued compensation and payroll taxes, accrued rent, accrued income and other taxes, unredeemed stored value cards and gift certificates, current portion of deferred lease credits, and other liabilities and accrued expenses.

4 Financial = Average Total Assets = ($1,605,649+$1,987,484) / 2 = $1,796,566.5 = 1.40Leverage Average Stockholders’

Equity($1,155,552+$1,417,312) / 2 $1,286,432

Thus, for every $1 of equity investment, American Eagle Outfitters maintains $1.40 of assets, with the additional $0.40 financed by debt. This ratio indicates that American Eagle Outfitters does not rely heavily on debt financing.

5. The company spent $225,939,000 on purchasing property and equipment in the year ended 2/3/07; $81,545,000 in the year ended 1/28/06; and $97,288,000 in the year ended 1/29/05. This information is listed on the Statement of Cash Flows in the investing activities section.


CP2–2.

1. Assets = Liabilities + Shareholders’ Equity $899,251,000 = $223,968,000* + $675,283,000

* Liabilities are determined by either adding current ($135,318,000) and non-current liabilities ($88,650,000) or by solving the accounting equation: Assets ($899,251,000) = Liabilities + Shareholders’ Equity ($675,283,000)

2. No – shareholders’ equity is a residual balance, meaning that the shareholders will receive what remains in cash and assets after the creditors have been satisfied. It is likely that shareholders would receive less than $675,283,000. In addition, assets on the balance sheet are not stated at market value, only historical cost.

3. The company’s only noncurrent liability is deferred rent.

4. Financial = Avg. Total Assets = ($769,205+$899,251) / 2 = $834,228 =1.35Leverage Avg. Stockholders’

Equity($560,880 + $675,283) / 2 $618,081.5

5. The company had a net cash outflow from investing activities of $201,408,000, primarily because of the purchase of investments and capital expenditures.


CP2–3.

1. Industry Average

American Eagle Outfitters

Urban Outfitters

Financial leverage = 1.77 1.40 1.35

Both American Eagle Outfitters’ and Urban Outfitters’ financial leverage ratios are lower than the industry average of 1.77. Therefore they finance their assets with less debt than the average company in their industry.

Renting store space instead of buying store space will cause American Eagle Outfitters’ and Urban Outfitters’ financial leverage ratios to be lower. Renting is a form of financing that does not show up in the liabilities section of the balance sheet. If they purchased store space by borrowing (instead of selling additional stock), the numerator (Average Total Assets) would increase, but the denominator (Average Stockholders’ Equity) would stay the same.

2. During the most recent year, American Eagle Outfitters spent $154,120,000 repurchasing common stock from investors and employees. Urban Outfitters spent $20,801,000 purchasing shares of its own common stock.

3. American Eagle Outfitters paid $61,521,000 in dividends. Urban Outfitters did not pay any dividends during the year. Refer to the financing activities section of the statement of cash flows.

4. Both American Eagle and Urban Outfitters report property and equipment combined as “Property and equipment, net.” Other companies sometimes choose to report these assets separately on the balance sheet, for example in accounts such as: “Land,” “Buildings and building improvements,” Furniture, fixtures and equipment,” and “Rental property and equipment.”


FINANCIAL REPORTING AND ANALYSIS CASES

CP2–4.

1. (a) Papa John’s total assets reported at July 1, 2007 are $402,582,000.

(b) Long-term debt including the current portion due increased over six months from $97,036,000 at December 31, 2006, to $126,784,000 on July 1, 2007.

(c) Financial = Avg Total Assets = ($379,639+$402,582) / 2 = $391,110.5 = 2.67Leverage Avg Stockholders’

Equity($146,168+$147,005) / 2 $146,586.5

Papa John’s financial leverage has increased from the level of 2.37 as discussed in the chapter. This indicates that, between December 31, 2006, and July 1, 2007, Papa John’s financed its assets with slightly more debt than previously. As discussed in the text, Papa John’s uses more debt than equity to finance its assets.

2. (a) For the six months ended July 1, 2007, Papa John’s spent $16,433,000 on the purchase of property and equipment.

(b) The total cash flows provided by financing activities was $6,596,000.


CP2–5.

1. Distressed investing occurs when an individual or organization purchases debt instruments or assets of companies facing financial trouble or bankruptcy, often during the “bust “ period following a boom in the financial markets. Often, the investor is looking for a relatively quick turnaround, betting that a new management, new strategy, or cheaper costs can lead to improved returns, and then is hoping to sell to a healthier rival to make a profit.

2. Investing in stocks is riskier than investing in bonds because debt holders have preference over stockholders upon liquidation of assets. However, those interested in distressed investing often take on more risk. The potential for greater returns if the company can be turned around is attractive to these investors and could yield a higher return than the interest on debt.

3. Mr. Ross studies companies extensively, primarily in industries with bleak outlooks, such as steel and textiles. He then “sells the stock short” (bets that the stock price will drop), then makes quick decisions to purchase at least one-third of the debt of these companies to ensure “he has the clout to protect his interests.” His attitude is strictly rational and he avoids situations that involve fraud or litigation. He also has limitless energy.

CP2–6.

The major deficiency in this balance sheet is the inclusion of the owner’s personal residence as a business asset. Under the separate-entity assumption, each business must be accounted for as an individual organization, separate and apart from its owners. The improper inclusion of this asset as part of Frances Sabatier’s business overstates total assets by $300,000; total assets should be $105,000 rather than $405,000, and stockholders’ equity should be only $5,000, rather than $305,000. Thus, the correct financial leverage ratio (based on the year-end balance sheet) is very high: 21.0 ($105,000 ÷ $5,000) versus 1.33 ($405,000 ÷ $305,000). Frances Sabatier’s business is far riskier than suggested by this balance sheet.


CP2–7.

1. The company is a corporation since its owners are referred to as “stockholders.”

2. Assets = Liabilities + Stockholders’ Equity (in millions)$1,656 = $1,385 + $271

3. Financial = Average Total Assets = ($1,921+$1,656)/2 = $1,788.5 = 6.80Leverage Average Stockholders’

Equity($255+$271)/2 $263.0

For every $1 of equity investment, Gateway maintains $6.80 of assets, with the additional $5.80 financed by debt. This ratio indicates that Gateway relies more heavily on riskier debt financing than on equity financing. The interpretation of this ratio would be more useful given information on the company’s financial leverage over time and on the typical financial leverage ratio for the computer industry.

4. Accrued liabilities (L).......................................................... 159Cash (A)........................................................................ 159

5. Over its years in business, it appears that Gateway has not been profitable. Gateway appears to have been profitable in its business during 2006. This is based on the 2005 balance in the accumulated deficit (negative retained earnings) account, which represents the cumulative deficit in earnings of the firm since the business began (including any dividends paid to the shareholders). Gateway reported an accumulated deficit for 2006, but the balance was less negative than in 2005, suggesting a gain for the year. Assuming no dividends were paid during the year, net profit in 2006 was $14 calculated as follows:

Accumulated Deficit

Beginning balance

717

Dividends 0

14 Net income

703 Ending balance (deficit)


CP2–8.

Req. 1McDonald’s Corporation

Balance Sheets At December 31, 2001 and December 31, 2010

(in millions of dollars)2011 2010

AssetsCurrent Assets:

Cash and equivalents $ 299.2 $ 341.4Accounts and notes receivable 609.4 483.5Inventories 77.3 70.5Prepaid expenses and other current assets 323.5 246.9 Total current assets 1,309.4 1,142.3

Property and equipment, net 16,041.6 14,961.4Intangible assets 973.1 827.5Investments in and advances to affiliates 854.1 634.8Notes receivable due after one year 67.9 67.0Other noncurrent assets 538.3 608.5 Total Assets $19,784.4 $18,241.5

LiabilitiesCurrent Liabilities:

Accounts payable $ 621.3 $ 650.6Accrued liabilities 783.3 503.5Taxes payable 237.7 201.0Notes payable 686.8 1,293.8Current maturities of long-term debt 168.0 335.6 Total current liabilities 2,497.1 2,984.5

Long-term debt 6,188.6 4,834.1Other long-term liabilities 1,574.5 1,491.0 Total Liabilities 10,260.2 9,309.6

Stockholders’ EquityContributed capital 1,065.3 787.8Retained earnings 8,458.9 8,144.1

Total Stockholders’ Equity 9,524.2 8,931.9 Total Liabilities and Stockholders’ Equity $19,784.4 $18,241.5


CP2–8. (continued)

Req. 2 Financial = Average Total Assets = ($18,241.5+$19,784.4) / 2 = $19,012.95 = 2.06Leverage Average

Stockholders’ Equity($8,931.9+$9,524.2) / 2 $9,228.05

Req. 3

For every $1 of equity investment, McDonald’s maintains $2.06 of assets, with the additional $1.06 financed by debt. This ratio indicates that McDonald’s utilizes debt financing slightly more than equity financing, and that McDonald’s utilizes debt financing more than the average company in the restaurant industry (with a ratio of 1.72 as indicated in the chapter).


CRITICAL THINKING CASES

CP2–9.

Req. 1Dewey, Cheetum, and Howe, Inc.

Balance SheetDecember 31, 2012

AssetsCurrent Assets:

Cash $ 1,000Accounts receivable 8,000Inventory 8,000

Total current assets 17,000Furniture and fixtures 52,000Delivery truck (net) 12,000Buildings (net) 60,000Total assets $141,000

LiabilitiesCurrent Liabilities:

Accounts payable $ 16,000Payroll taxes payable 13,000

Total current liabilities 29,000Notes payable (due in three years) 15,000Mortgage payable 50,000 Total liabilities 94,000

Stockholders' EquityContributed capital 80,000Accumulated deficit (33,000)

Total stockholders' equity 47,000Total liabilities and stockholders' equity

$141,000


CP2–9. (continued)

Req. 2

Dear ___________,

I corrected the balance sheet for Dewey, Cheetum, and Howe, Inc. Primarily, I reduced the amount reported for buildings to $60,000 which is the historical cost less any depreciation. Estimated market value is not a generally accepted accounting principle for recording property, plant, and equipment. The $38,000 difference ($98,000 – $60,000) reduces total assets and reduces retained earnings. In fact, retained earnings becomes negative suggesting that there may have been several years of operating losses.

The effect of the corrections also changes the financial leverage ratio (based on the year-end figures provided):

Prior to the correction ($179,000 ÷ $85,000) 2.11After the corrections ($141,000 ÷ $47,000) 3.00

This suggests that the company has assumed a proportionately larger debt burden than indicated on the original balance sheet.

Before making a final decision on investing in this company, you should examine the past three years of audited income statements and the past two years of audited balance sheets to identify positive and negative trends for this company. You can also compare this company's financial leverage ratio to that of the industry. You should also learn as much about the industry as you can by reviewing recent articles on economic and technological trends which may have an impact on this company.


CP2–10.

1. The most obvious parties harmed by the fraud at Ahold’s U.S. Foodservice Inc. were the stockholders and creditors. Stockholders were purchasing shares of stock that were inflated due to the fraud. Creditors were lending funds to the company based on inflated income statement and balance sheet information. When the fraud was discovered, the stock price dropped causing the stockholders to lose money on their investments. In addition, the creditors have a lower probability of receiving full payment on their loans. The vendors who assisted in verifying false promotional allowances were also investigated.

Those who were helped by the fraud included the former executives who were able to receive substantial bonuses based on the inflated results of operations. The SEC also charged two individuals with insider trading for trading on a tip illegally.

2. U.S. Foodservice set certain financial goals and tied the former executives’ bonuses to meeting the goals. Adopting targets is a good tool for monitoring progress toward goals and identifying problem areas, such as rising costs or sagging sales. Better decision making can result by heading off potential problems before they grow too large. However, setting unrealistic financial targets, especially in poor economic times, can result in those responsible for meeting the targets circumventing appropriate procedures and policies for their own benefit.

3. In many cases of fraudulent activity, auditors are named in lawsuits along with the company. If the auditors are found to be negligent in performing their audit, then they are liable. However, in many frauds, the management at multiple levels of the organization are so involved in covering the fraud that it becomes nearly impossible for the auditors to detect the fraudulent activity. In this case, it appears that top executives concocted a scheme to induce vendors to confirm false promotional allowance income by signing audit letters agreeing to the false amounts. In audits, confirming balances or amounts with external parties usually provides evidence for the auditors on potential problem areas. The auditors appropriately relied on this external evidence in performing its audit, not knowing it to be tainted or fraudulent.

FINANCIAL REPORTING AND ANALYSIS TEAM PROJECT

CP2–11.

The solution to this team project will depend on the companies and/or accounting period selected for analysis.


Documents

chap002 AccountingMBA